Systems of Accounting, Basis of accounting (Cash & Accrual Basis)

Systems of Accounting, Basis of accounting (Cash Basis & Accrual Basis). Difference between Accrual Basis of Accounting and Cash Basis of Accounting.

Cash Basis of accounting:

Cash Basis of Accounting is a method of recording transactions by which revenues, costs, assets and liabilities are reflected in the accounts for the period in which actual receipts or actual payments are made. It is a system in which accounting entries are made only when cash is received or paid. No entry is made when a payment or receipt is merely due. In other words, it is a system of accounting in which revenues and costs and assets and liabilities are reflected in the accounts in the period in which actual payments or actual receipts are made in cash. It may not treat any revenue to have been earned or even sales to have taken place unless cash is actually paid by customers. It has no relevance whether the receipts pertain to previous period or future period. Similarly, expenses are restricted to the actual payments in cash during the current year and it is immaterial whether the payments have been made for previous period or future period.

Cash basis of accounting is incompatible with the matching principle of income determination. Hence, the financial statements prepared under this system do not present a true and fair view of operating results and financial position of the organization. However, cash system of accounting is suitable in the following cases:

(i) Where the organization is very small or in the case of individuals, where it is difficult to allocate small amounts between accounting periods; and

(ii) Where credit transactions are almost negligible and collections are uncertain e.g. accounting in case of professionals i.e. doctors, lawyers, firms of chartered accountants/company secretaries. But while recording expenses, they take into account the outstanding expenses also. In such a case, the financial statement prepared by them for determination of their income is termed as Receipts and Expenditure Account.

Accrual System of Accounting:

Accrual Basis of Accounting is a method of recording transactions by which revenue, costs, assets and liabilities are reflected in the accounts for the period in which they accrue. This basis includes consideration relating to deferrals, allocations, depreciation and amortization. This basis is also referred to as mercantile basis of accounting. This is also known as mercantile system of accounting. It is a system in which transactions are recorded on the basis of amounts having become due for payment or receipt. Accrual basis of accounting attempts to record the financial effects of the transactions, events, and circumstances of an enterprise in the period in which they occur rather than recording them in period(s) in which cash is received or paid by the enterprise.

It recognizes that the buying, selling and other economic events that affect enterprise’s performance often do not coincide with the cash receipts and payments of the period. The purpose of accrual basis accounting is to relate the revenue earned to cost incurred so that reported net income measures an enterprise’s performance during a period instead of merely listing its cash receipts and payments. Accrual basis of accounting recognizes assets, liabilities or components of revenues and expenses received or paid in cash in past and expected to be received or paid in cash in the future. The following are the essential features of accrual basis:

  • Revenue is recognized as it is earned irrespective of whether cash is received or not;
  • Costs are matched against revenues on the basis of relevant time period to determine periodic income, and
  • Costs which are not charged to income are carried forward and are kept under continuous review. Any cost that appears to have lost its utility or its power to generate future revenue is written off as a loss.

Difference between Accrual Basis of Accounting and Cash Basis of Accounting

Basis of Distinction Accrual Basis of Accounting Cash Basis of Accounting
Prepaid/Outstanding Expenses / accrued/ unaccrued Income in Balance Sheet. Under this, there may be prepaid/ outstanding expenses and accrued/ unaccrued incomes in the Balance Sheet. Under this, there is no prepaid /outstanding expenses or accrued /unaccrued incomes
Higher/lower Income in case of prepaid expenses and accrued income Income Statement will show a relatively higher income Income Statement will show lower income.
Higher/lower income in case of outstanding expenses and unaccrued income Income Statement will show a relatively lower income. Income Statement will show higher income.
Availability of options to an accountant to manipulate the accounts by way of choosing the most suitable method out of several alternative methods of accounting e.g. FIFO/LIFO/SLM/WDV Under this, an accountant has options. Under this an accountant has no option to make a choice as such.

Hybrid or Mixed Basis Under the hybrid system of accounting, incomes are recognised as in Cash Basis Accounting i.e. when they are received in cash and expenses are recognised on accrual basis i.e. during the accounting period in which they arise irrespective of when they are paid.

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